IN CIGARETTE INDUSTRY, BURNING ISSUE IS SURVIVAL Expansion abroad has U.S. downside

THE BALTIMORE SUN

When food and tobacco giant Philip Morris gave Wall Street investors a recent update on its financial health, it released a little-noticed but startling fact: For the first time in the company's 75-year history, it made more money selling cigarettes to foreigners than to Americans.

Given tobacco's uncertain future in this country, that news looked like a example of smart corporate diversification. Americans may be avoiding cigarettes in droves and the federal government threatening to regulate tobacco like a drug, but at least foreigners are coming to Marlboro Country.

But like so much in the tobacco business, even this silver lining is clouded by unexpected problems.

International operations have indeed bolstered profits, but by focusing operations overseas and importing tobacco, the tobacco companies have contributed to layoffs at home and a steady squeeze of U.S. tobacco farmers.

The result: once-loyal supporters of the big tobacco companies have disappeared, leaving the companies vulnerable as they face an implacably hostile Congress.

These endless problems with tobacco are forcing the nation's two cigarette-making and food-processing giants -- Philip Morris Cos. and RJR Nabisco Holdings Corp. -- to ask a question that would have been unthinkable a few years ago: Is lucrative tobacco worth all the hassle?

The answer may be no. Both companies are weighing radical plans to dump their tobacco divisions, a move that would strip them of tobacco's fat profits but also free them from its endless series of lawsuits, taxes and restrictions. And just last month , the nation's fourth-largest tobacco manufacturer, American Brands Inc., announced that it was selling its tobacco division to a British company.

"It's crunch time for the tobacco companies. Diversification has not been working as well as they thought, and even overseas expansion has its drawbacks. There's no clear way out for them," said David Tice, a tobacco industry analyst based in Dallas.

Only a few years ago, making cigarettes was anything but the problem child of U.S. industry.

As the 1980s drew to a close, corporate raiders fought for the right to own RJR Nabisco and its Camel, Winston and Salem cigarette brands. When the buyout of RJR was completed in 1989, new owners Kohlberg Kravis Roberts & Co. had spent $29.6 billion in a leveraged buyout of the company, going massively into debt on the premise that tobacco could easily pay it all off in short order.

"I'll tell you why I like the cigarette business," billionaire investor Warren Buffett is reported to have said when asked why so much was being bid for RJR Nabisco. "It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty."

Today, cigarettes still cost just pennies to make, but that dollar sale price is increasingly made up of taxes. Meanwhile, the addiction is spurring damaging government inquiries and the brand loyalty is dependent on lower prices and dangerously bloated marketing budgets.

Another vanishing advantage allowed RJR Nabisco and Philip Morris to increase prices virtually at will. Between 1984 and 1993, prices for tobacco products shot up at nearly twice the rate of inflation, according to the U.S. Department of Agriculture. The reason was not prices for tobacco, which declined during that time, but because profit margins zoomed upward.

Those salad days ended just after the RJR Nabisco buyout. As the economy slowed and cigarette prices continued to rocket upward by 10 percent a year, low-cost "generic" cigarettes became a serious force in the market. Between 1988 and 1993, the number of generic cigarettes rose threefold, from 62 billion cigarettes to 180 billion, making up 40 percent of the U.S. cigarette market.

Meanwhile, sales of premium cigarettes, such as Marlboro, declined from 501 billion cigarettes to 295 billion.

The companies responded a year ago by cutting the price of a pack of premium cigarettes by 40 cents -- a move that cost Philip Morris $2 billion in 1993. They are regaining market share from the generics, but have had to sacrifice tobacco's legendary profit margins.

Last year, for example, Philip Morris' profits fell 37.4 percent to $3.09 billion, while RJR Nabisco's profits dropped 43 percent last year to $464 million.

Now, Mr. Buffett tells another story when asked about tobacco: "I would not like to have a significant percentage of my net worth invested in tobacco businesses."

As smoking became a riskier business over the past decade, the tobacco companies started diversifying. R. J. Reynolds Industries Inc. merged with Nabisco Brands Inc. in 1985, while Philip Morris snatched up Kraft foods in 1988. That gave RJR Nabisco household products, such as Oreo cookies, Planters peanuts and Ritz crackers, while Philip Morris rounded out its cigarettes with Kraft cheeses, Breyers and Sealtest ice cream, Oscar Mayer meats and Kool-Aid drinks.

These popular brands looked like a good antidote to tobacco's ** problems, but even here the companies have found themselves beset by problems that are similar to some of tobacco's woes: Penny-wise consumers are forsaking name brands for low-priced generic goods.

Leading the way have been chains of supermarkets, such as Giant, which offer similar products under their own label.

"Private labels won't take over the food business by any means, but we are seeing a change in how brand-name products are perceived," said Richard De Santa, executive editor of Supermarket Business, a trade magazine. "They're no longer seen as inferior, so customers are willing to give up well-known old brands."

This challenge is hardly of the magnitude facing the companies' tobacco business, but it's been enough to keep profits thin and inadequate to compensate for tobacco, Wall Street analysts say.

"Nothing makes money like tobacco. Selling food is a fine business, but how much money do you make on a quart of milk or a bag of cookies?" said Edward A. Froelich, a Philip Morris analyst with Pershing Securities.

Indeed, RJR Nabisco still counts on tobacco for a disproportionately high percentage of its profits. Tobacco provides 53 percent of its revenues, but 65 percent of its profits, despite all the trouble with price cuts and declining smoking. Figures are similar for Philip Morris.

Both companies have fought back against lower profits by closing down factories and laying off workers. Philip Morris, for example, plans to slash 8 percent of its work force -- 14,000 positions -- and close or scale back 40 factories over the next three to four years. RJR Nabisco is to cut 9 percent of its work force -- 6,000 employees.

Most importantly, however, both companies are contemplating divesting their tobacco operations, much as American Brands did in April. The Connecticut company, which makes Lucky Strike and Pall Mall, sold its American Tobacco Co. for $1 billion to B.A.T. Industries PLC, the world tobacco giant based in London that makes Cool, Raleigh, Viceroy and Belair and already owns the third-largest U.S. tobacco company, Brown & Williamson.

Not coincidentally, American Brands announced disappointing earnings the same day that it announced the sale of American Tobacco. Tobacco caused the company's revenues to fall by 13 percent during the first three months of this year, and profits slid 40 percent.

Philip Morris and RJR Nabisco have not announced anything so dramatic as American Brands' decision to give up on tobacco, but they have made some stabs at putting a wall between their relatively healthy food operations and tobacco.

Threats depress stocks

Last year, RJR tried to issue a new class of stock tied to the performance of its food businesses. That offering fell through, but RJR has been trying to shore up its finances by issuing other types of stocks and bonds.

And just last month Philip Morris said it was considering splitting its food and tobacco businesses. The reasoning is that the company's stock is being depressed by threats from Washington to regulate or heavily tax cigarettes. If the food and tobacco companies had their own stocks, the food stock would be able to rise to its true value.

The company's stock rallied, but after its board took no action Wednesday to split the business lines, Philip Morris shares tumbled about 6 percent, closing Friday at $50.

One of the most heralded diversification tactics of the past decade has been selling cigarettes overseas.

This has helped increase revenues and profits, but only to a limited degree. Selling cigarettes overseas is less profitable than selling to Americans -- in part because many sales overseas are to developing countries, where residents can't afford to pay as much. To make the sale, tobacco companies have to accept lower profits, said John Maxwell, a Wheat First analyst.

Last year, for example, foreign sales made up 40 percent of RJR Nabisco's tobacco sales, but only 30 percent of its profits before one-time restructuring charges. Likewise, Philip Morris generates 60 percent of its tobacco revenues overseas, but only half its profits.

Political cost is growing

Still, the figures show that both companies are doing a lot of business overseas. Especially for Philip Morris, which made $769 million in profits from domestic sales and $791 million from foreign sales -- the first time overseas profits had overtaken domestic sales -- international diversification seems to be working.

This has come at a growing political cost, however, as the tobacco companies' overseas focus has left them without as much influence in key tobacco-growing states.

The export offensive, for example, has not helped many domestic producers of cigarettes. Production has fallen by 100 billion cigarettes since 1981 to an estimated 625 billion this year. One reason: both Philip Morris and RJR Nabisco are spending billions on factories overseas, where lower costs allow them to sell cigarettes more cheaply. In Eastern Europe, for example, Philip Morris has invested $1 billion to build facilities or buy existing factories. The company's most recent investment overseas was a $200 million cigarette factory in Kazakhstan.

Venture opens in China

R. J. Reynolds has also invested overseas. It recently opened a joint venture, China-American Cigarette Co., in the coastal city of Xiamen. The factory will produce 2.5 billion cigarettes annually, including well-known American brands Winston and Camel. The tobacco leaf comes from Chinese growers, who are being helped by the companies to improve their leaf quality.

Exports of unprocessed tobacco leaf have also stagnated over the past five years, meaning few farmers have benefited from the companies' government-aided expansion overseas.

This trend has weakened the U.S. tobacco industry's influence in Washington. Once able to equate their welfare with jobs for U.S. growers and factory workers, the tobacco companies are finding that this argument is not as strong as before.

Farmers used to form another backbone of tobacco's power in Washington. But the growers themselves are increasingly fed up with the companies' practice of favoring cheaper imported tobacco. The tobacco industry's march on Washington March 9, for example, had relatively few tobacco farmers.

"When Philip Morris asks me to get on a bus and go protest, I say forget it. If they want to support farmers, they could buy our crop," said Andy Shepherd, vice president of the Flue-Cured Tobacco Cooperative Stabilization Corp. in Virginia.

Institute suffers

Meanwhile, even the legendary Tobacco Institute, the tobacco industry's lobbying arm, has been hit by the industry's problems. Low profits have meant that the companies have less money to contribute to the institute, which recently cut its staff 40 percent. Those cuts, in turn, weaken tobacco's voice in Congress to oppose the stream of new regulations, higher taxes and anti-tobacco rhetoric flowing out of the district.

"It's still a $45 billion industry, which is a substantial chunk of PTC change. But it's clearly not what it was," said Norman Ornstein, a Congress-watcher with the American Enterprise Institute. "As they cut employment, they lose influence. They've lost a lot of legitimacy and influence in Washington."

TOMORROW: Tobacco companies abandon U.S. tobacco i favor of cheap tobacco and new markets overseas -- with help from the federal government.

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